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- Pipeline disinflation is becoming clearly visible
- But the Fed is likely to hold rates at 5% through 2023
- That implies a sharp rise in real interest rates
- To varnish its credibility, the Fed may tighten excessively and ensure a protracted recession
- Or, a sharp market selloff can trigger easing, which may soften slowdown, but keep prices sticky
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Commentary: Assessing risks of two-sided errors by the Fed
At the end of a year of mega rate hikes, the US Federal Reserve is poised to begin downshifting. From speeches of various Fed officials to market-based forecasts, stars are aligned for a 50bps rate hike on December 14th. Market pricing has also converged for another 50bps points of rate hikes left in this cycle, to take place in 1Q of next year. With inflation having peaked already, and manufacturers’ survey suggesting disinflation in the pipeline, the Fed would be keen to confirm the market’s view of 5% terminal rate in this cycle.
But then what? Should the Fed keep the policy rate at 5% for the remainder of the year as the pace of disinflation is unlikely to be sufficient to convince them that its 2% inflation target is back in play? Or should it begin signaling its intent to ease monetary conditions? After all, by the beginning of 2Q, it will likely be clear that the economy is heading into considerable slowdown, if not an outright recession.
This dilemma is particularly tricky, as chances are that the Fed would end up making a policy error in either direction—overtightening or premature easing.
Over tightening
If the Fed holds the policy rate at 5% next year, the pipeline disinflation we envisage would push up real interest rate by over 200bps through the course of the year. Substantially positive real rates would most likely translate into a major drag to credit growth and consumption. It may also lead to debt distress and a pronounced slowdown in investment. Holding the rate unchanged through 2023 may end up being a bit too much for the economy to absorb, which is what the fixed income market is asserting in its pricing. In its adamance to varnish its credibility, the Fed may end up causing excessive tightening and ensure a protracted recession, and yet, at the end of the day, not achieve 2% inflation in 2023 or 2024.
Premature easing
The Fed’s track record is of course one of being market friendly, and cutting readily to counter financial market distress, seen most recently in 2019. While the present rhetoric around inflation is tough, would it remain so if global markets sell off sharply, financial stability concerns rise around tightening liquidity, and demand begins to soften? If the past is any indication, the Fed may then change track and cut expeditiously, which may ease the economic slowdown and support markets, but cause inflation to remain sticky. We have heard Fed Chair Powell worry about this risk in his recent deliberations, but would not rule out the chance of this error from materialising.
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